TAX POSITIONS FOR FLOWTHROUGH ENTITIES: WHAT IS AN INCOME
by: Kathleen K.Wright, CPA, MBA, JD, LLM and Jack Small, CPA,
Featured in: The Tax Adviser | June
held business entities were swept up into the complexity of accounting for
uncertainty in income taxes in 2009. Financial Accounting Standards Board (FASB)
Accounting Standards Codification (ASC) Topic 740, relating to accounting for
uncertainty in income taxes, requires evaluation and disclosure of the risk
associated with uncertain tax positions taken or expected to be taken in a tax
The portion of ASC 740 formerly known as FIN 48 was
effective for fiscal years beginning after December 15, 2006, for publicly
traded companies and was made applicable to all business enterprises including
not-for-profit organizations, passthrough entities, real estate investment
trusts, and registered investment companies for years beginning after December
column examines the unique state tax issues that arise under ASC 740 for
privately held business entities that are organized as flowthrough entities. For
federal purposes, only a small percentage of flowthrough entities pay income
taxes, with the most notable exception being certain S corporations. If the
scope of ASC 740 did not extend beyond federal law, the number of flowthrough
entities subject to the analysis would be minimal. For state purposes, a
significantly larger population of flowthrough entities will be subject to this
analysis as states move toward assessing various types of gross receipts taxes
on flowthrough entities. States have adopted gross receipts tax structures in
lieu of the more traditional income tax as a means of expanding their tax base
under the guise of relative ease of administration and the lack of complexity in
their calculation. This column discusses assessments made by various states to
determine whether they are income taxes and subject to the ASC 740 analysis.
of an Income Tax
740 applies only to business entities subject to income taxes. The question of
whether a wide variety of state taxes fall under the rubric "income taxes" has
raised vexing questions, including whether the assessment is subject to
apportionment, state constitutional standards, income tax nexus standards (such
as P.L. 86-272), treatment on the state return (i.e., deductible as a fee or
creditable as a tax paid to other states), and applicability of ASC 740.
states (most notably Texas, Michigan, Ohio, and recently Oklahoma) have enacted
tax systems that have characteristics of both sales and income taxes. These
states (and others) have issued their own opinions on whether these assessments
are income taxes or are more in the nature of fees. These determinations
generally deal with whether the levy is a sales and use tax or an income tax
and, if an income tax, whether it is deductible on the state return. The results
are far from consistent.
740-10-20 defines "income tax" as domestic and foreign federal (national),
state, and local (including franchise) taxes based on income. While ASC 740 does
not include a definition of "income subject to tax," it does include a
definition of certain types of assessments to which ASC 740 does not apply. It
does not apply to a franchise tax to the extent it is based on capital and there
is no additional tax based on income. If there is an additional tax based on
income, that excess is considered an income tax and is subject to ASC
In August 1991, State A amended its franchise tax statute, effective January 1,
1992, to include a tax on income apportioned to the state based on the federal
tax return. The amount of franchise tax on each corporation was set at the
greater of 0.25% of the corporation's net taxable capital or 4.5% of the
corporation's net taxable earned surplus. Net taxable earned surplus was defined
in the state statute by reference to the corporation's federal taxable
740-10-55-141 concludes that the total computed tax in this case "is an income
tax only to the extent that the tax exceeds the capital-based tax in a given
year." Only that portion of the tax is subject to the analysis required under
this very broad definition, most state assessments, including some franchise
taxes based on earned surplus or income taxes, qualify as income tax payments
under the umbrella of ASC 740. Assessing a tax on the earned surplus implies
that an income tax is assessed if the base of the tax is reduced by at least
some deductions. This is the approach taken by most practitioners with respect
to the applicability of ASC 740, although this is not the approach taken by the
states when they analyze taxes for purposes of determining deductibility.
increasing number of state assessments are based on gross receipts or gross
income and exhibit characteristics of both fees and income taxes. Various state
and local taxes may have income tax–like elements that can potentially belie
their nomenclature as something other than an income tax. When compared with net
income taxes, the most significant difference is that deductions are not
permitted. Several of these taxes are discussed here to the extent that they
have spawned controversy.
The Texas Margin Tax
January 1, 2008, Texas changed its former franchise tax to a margin tax. The
margin tax is described as a tax based on gross receipts with certain allowable
deductions.4 The taxable margin is computed based on
the lesser of:
Texas margin tax is assessed on S corporations, partnerships, limited liability
partnerships (LLPs), limited liability companies (LLCs), and single-member LLCs
(SMLLCs) at the entity level.5 Several states (including Texas in its
own legislative history) have opined on whether the Texas margin tax is an
income tax, with inconsistent results. The Texas Legislature's Enrolled Bill
Summary6 makes clear that the restructured
franchise tax is not an income tax and that the federal law concerning state
taxation of income from interstate commerce (i.e., P.L. 86-272) does not apply.
In addition, the bill analysis states that the attorney general indicated that
the plan would not constitute an income tax and likely would be upheld in
court.7 These assurances were necessary to
address concerns that the Texas margin tax would run afoul of Article VIII,
Section 24(a), of the Texas constitution, which prohibits enactment of a law
that imposes a tax on a person's net income, including a person's share of
partnership and unincorporated association income, unless a majority of Texas
voters approve such a tax in a statewide referendum.8
Margin Tax Is Not an Income Tax: Minnesota,Virginia, Massachusetts
states have rendered an opinion on whether the Texas margin tax is a tax
measured by net income for purposes of deductibility on the state income tax
return or eligibility for the credit allowed for income taxes paid to other
states. The Minnesota Department of Revenue (DOR) has taken the position that
the Texas margin tax is not an income tax because certain deductions such as
interest, depreciation, and most other business expenses generally associated
with a computation of net income are not allowed.9 Using a similar analysis, Virginia and
Massachusetts have taken similar positions.10
Margin Tax Is an Income Tax: Kansas, South Carolina, Missouri
2008 the Kansas DOR issued Opinion Letter No. O-2008004,11 stating that the revised Texas margin tax
is an income tax that must be added back in the computation of the corporate
income tax and that it can also be claimed as a credit for taxes paid to another
state. However, it later refined its response in Opinion Letter No.
O-2009-00512 by stating that the Texas margin tax is
only an income tax (and not deductible) if it is determined by deducting COGS or
South Carolina DOR ruled that the Texas margin tax is an income tax that must be
added back to the tax base.13
Missouri DOR held in Letter Ruling LR 530914 that the Texas margin tax is an income
tax. This finding was based on Herschend v. Director of
Revenue,15 where the Missouri Supreme Court found
that a Tennessee excise tax was an income tax paid to another state and was
creditable against Missouri income tax under two tests—the based-on test and the
object test. Under the based-on test, the court looked to determine if the tax
was based on net earnings earned within Tennessee, defined by reference to
federal taxable income. The court determined that the tax was calculated just
like the Missouri income tax, as a fixed percentage of total income. The
Missouri DOR found that the Texas margin tax is also based on various types of
income reported on the federal income tax return and that it meets the based-on
test in Herschend and therefore meets the standard of based-on income.
object test addresses the critical distinction between an income tax and a
franchise tax. An income tax is imposed to compensate the state for benefits
already received, while a franchise tax is imposed and payable in advance for
the privilege of exercising the right to do business in the state in the future.
An income tax is imposed even if a corporation ceases to do business during a
particular year in which it has generated income. A franchise tax is not
imposed, as there is no business activity contemplated in the future. The Texas
margin tax is compensatory in nature and will apply to compensate the state for
public benefits such as roads, schools, police and fire protection, and so
forth, so it is classified as an income tax.16
FTB Notice 2010-02,17 the California Franchise Tax Board (FTB)
stated that the determination of whether the Texas margin tax is an income tax
is highly fact specific and must be analyzed on a case-by-case basis, determined
largely by the different types of taxpayers (and various types of revenue) that
may be subject to the margin tax. The ruling concludes that if the tax is
determined to be a gross receipts tax, it would be deductible on the state
income tax return (as a fee). The ruling defines a gross receipts tax as a tax
imposed on gross income (without allowing a deduction for costs of goods sold,
referred to in the notice as a return of capital). The tax would not be
deductible on the California return if it were considered a gross income tax or
a net income tax.
FTB Notice 2010-02 appears to give California the ability to make such
determinations on the Texas tax as needed, it would also appear, based on
numerous opinions and rulings spanning several decades regarding the
determination of a gross receipts tax, that it would be difficult for California
to ever rule that the Texas tax is an income tax. Cases such as Beamer v.
Franchise Tax Board,18
of Dayton Hudson,19 and Appeal of Kelly
determined that various state taxes such as the Texas occupation tax (a tax on
oil and gas production) and the Michigan single business tax are gross receipts
taxes because they do not allow for a complete deduction of COGS.
Texas margin tax includes its own computation of COGS.21
the computation tends to follow federal law, there are exceptions, particularly
with the definition of capitalizable overhead.22 All the Texas margin tax computations
deny the deduction of expenses commonly deducted in computing net income. The
definition of COGS limits the deductibility of overhead, and, even if overhead
is fully deductible, based on Appeal of Kelly Services, the mere possibility of
this deduction's being limited would compel California to deem the tax a gross
receipts tax. The definition of compensation limits the compensation deduction
to $300,000 per employee per 12-month period.23 Thus, there does not appear to be any
scenario in which the Texas margin tax would qualify as a net income tax for
these varied opinions by the states, the FASB determined that the Texas margin
tax was an income tax to be accounted for in accordance with FAS 109, Accounting
for Income Taxes.24 ASC 740 does not specify what type of
deductions must be allowed to qualify the assessment as an income tax; it only
implies that some deductions must be allowed to qualify the assessment as an
with the tax period that commences July 1, 2005, Ohio levies a commercial
activity tax (CAT) on each person with taxable gross receipts for the privilege
of doing business in the state. Taxpayers subject to the CAT include all
businesses conducted for the purpose of generating gain, profit, or
income.25 This includes partnerships, LLPs, LLCs, S
corporations, and any other entity engaged in business in Ohio.26
receipts subject to the CAT are broadly defined to include most business types
of receipts from the sale of property or realized by the performance of a
service. Specifically, "gross receipts" means the total amount realized by a
person, without deduction for the COGS or other expenses incurred, that
contributes to the production of the person's gross income, including the fair
market value of any property and any services received, and any debt transferred
or forgiven as consideration.27
the Ohio Supreme Court held in Ohio Grocers Association v.
Levin28 that the tax operates like an income tax
on the privilege of doing business in the state, many other states have ruled
differently for purposes of determining whether an addback is required or
whether a credit is allowed for taxes paid to other states. Based on the
rationale that the computation of the tax does not allow for any deductions from
income or receipts, states such as Minnesota,29
Massachusetts,30 South Carolina,31 and Wisconsin32 all treat the CAT as a tax on gross
receipts rather than a tax on income.
Although the FASB has not directly opined on the nature of the Ohio CAT, ASC 740
should not apply to the Ohio CAT because the tax base is not reduced by
are three components to the Michigan business tax (MBT): the business income tax
(BIT), the modified gross receipts tax (MGRT), and the annual surcharge. The BIT
and the MGRT are based on an income base similar to federal taxable income. The
total of the two is then multiplied by the surcharge rate. The BIT starts with
business income and, being based on federal taxable income, is clearly an income
law states that the MGRT is imposed on the privilege of doing business and not
upon income or property.34 It is computed based on the taxpayer's
gross receipts less purchases from other firms before apportionment.
annual surcharge is based on a percentage of the taxpayer's MBT liability after
allocation or apportionment to Michigan.35 The MBT is imposed on S corporations,
partnerships, LLPs, LLCs, and SMLLCs.36
MBT Is an Income Tax: Missouri
Letter Ruling LR 5309,37 the Missouri DOR held that all three
components of the MBT are income taxes. Pursuant to Herschend, the MBT was held
to be an income tax because it is essentially based on federal income tax.
Receipts Portion of the MBT Is Not an Income Tax: South Carolina and Kansas
the South Carolina DOR and the Kansas DOR have both ruled that the modified
gross receipts portion of the MBT is deductible because it does not qualify as a
net income tax, while the business income tax portion is not deductible because
it is an income tax.38
FASB has not ruled on the MBT, but since the base of all three components is
taxable income after certain deductions, it should be subject to the ASC 740
has enacted a business activity tax (BAT) for the 2010–2012 tax
years.39 In addition, the state has placed a
moratorium on the franchise tax for periods beginning July 1, 2010, and ending
before July 1, 2013.40 For the 2010–2012 tax years, the BAT is
imposed on all persons doing business in the state in an annual amount of
$25.41 In addition to that annual tax, persons
doing business in Oklahoma are subject to a tax in the amount of 1% of the net
revenue derived from business activity that is allocated or apportioned to the
state.42 However, for the 2010–2012 tax years,
those subject to the Oklahoma franchise tax are liable for the amount of their
franchise tax liability from the period ending prior to December 31, 2010,
rather than the tax based on net revenue.43 Corporations, partnerships, and LLCs are
all subject to the BAT.44
imposition of the BAT is in response to the case of Southwestern Bell v.
Oklahoma State Board of Equalization,45
which the Oklahoma Supreme Court ruled that intangible personal property was
subject to the state's ad valorem tax unless specifically exempt by the state
constitution. Since the ruling resulted in a significant tax increase for many
Oklahoma taxpayers, the BAT was enacted as a temporary solution because it is
imposed in lieu of all other taxes on intangible personal property (with a few
exceptions).46 The BAT is curious in that it is set to
expire after 2012 unless it is reenacted by the legislature, yet it contains a
provision for a tax on net revenues that cannot statutorily be imposed during
the current expected life of the BAT.
the recent enactment of the BAT, other states have not yet offered an opinion as
to whether it would constitute an income tax for purposes of state tax addback
or credit for taxes paid to other states. Furthermore, Oklahoma has not yet
offered an opinion on whether the BAT is considered an income tax when applying
P.L. 86-272. However, Oklahoma has expanded its definition of "doing business"
for purposes of the BAT to incorporate a factor presence
standard,47 which leads one to believe that the state
might consider P.L. 86-272 to be inapplicable to the BAT. For tax years
2010–2012, since the BAT is limited to a flat fee of $25 and the amount of the
taxpayer's franchise tax liability from the period ending prior to December 31,
2010, it does not seem likely that the BAT would be considered an income tax.
However, assuming the BAT continues to exist after 2012 and is truly based on
net revenue, its classification could certainly change.
order to calculate net revenue for purposes of the BAT, taxpayers start with
total revenue, which is defined as revenue reported on the federal income tax
return or total revenue received or accrued if a federal income tax return is
not required to be filed less specific exclusions, including certain items of
interest, dividends, real estate rentals, royalty interests, net capital gains,
and compensation.48 Total revenue is then reduced by all
ordinary trade or business expenses other than interest, income taxes,
depreciation, and amortization in order to arrive at net
that the law allows numerous deductions in order to arrive at the tax base, the
BAT has many characteristics of a typical income tax. However, as noted above,
states have gone in both directions with similar taxes, with some ruling that
they constitute income taxes and others deciding the opposite. When reviewing
the FASB's rationale that the Texas margin tax is an income tax because some
deductions are allowed in arriving at the tax base, it seems reasonable that the
FASB would draw the same conclusion for the BAT.
is clear that the categorization of state payments assessed on flowthrough
entities as an income or gross receipts tax depends on the purpose for which the
question is asked. For purposes of ASC 740 and the analysis of uncertain tax
positions, the definition found in ASC 740-10-20, which defines taxable income
as the excess of taxable revenues over tax-deductible expenses and exemptions
for the year as defined by the governmental tax authority, means that state
assessments with some allowance for deductions would fall under the scope of
means that the ASC 740 analysis must be completed for flowthrough entities
publishing financial statements under GAAP and doing business in states such as
California, the District of Columbia, Illinois, Kentucky, Massachusetts,
Michigan, New Hampshire, Tennessee, Texas, and Wisconsin.50 This makes the extension of ASC 740 to
flowthrough entities a much more extensive reporting requirement than most
practitioners initially thought; many had considered only the very limited
situations in which a flowthrough entity might be subject to a federal income
tax as the scope of this new reporting requirement.
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1 In June 2009, FASB issued FAS No. 168, FASB Accounting Standards
Codifcation and Hierarchy of Generally Accepted Accounting Principles, effective
for fnancial statements issued for interim and annual periods ending after
September 15, 2009. Following the issuance of FAS 168, the FASB will now issue
Accounting Standards Updates that will update the codifcation, provide
background information about the guidance, and give explanations for the changes
made to the codifcation. FAS 109, Accounting for Income Taxes, is now
published in the codifcation at ASC 740. FIN 48 (FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes) is located at ASC 740-10-05 to
3 See ASC
740-10-55-139–144, Example 17.
4 TX Tax Code Ann.
§§171.001 and 171.101.
5 TX Tax Code Ann.
§§171.001(a) and 171.0002.
6 TX State
Legislature, Enrolled Bill Summary, House Bill 3 (3rd C. S.),
Legislative Session 79(3).
7 House Research
Organization, Bill Analysis: Restructuring the Texas Franchise Tax, p. 12
8 See Laing, "An
Income Tax by Any Other Name Is Still an Income Tax:
The Constitutionality of the Texas
Margin Tax as Applied to Partnerships and Other Unincorporated Associations," 62
Baylor L. Rev. 573 (Spring 2010).
9 MN Revenue Notice 08-08 (7/21/08).
10 VA Dep't of Tax'n, Ruling of the Comm'r PD 08-169 (9/11/08); MA
DOR Directive 08-7 (12/18/08).
11 KS DOR Opinion Letter No. O-2008-004 (9/2/08).
12 KS DOR Opinion Letter No. O-2009-005 (3/24/09).
13 SC Rev. Rul. 09-10 (7/17/09).
14 MO DOR Letter Ruling LR 5309 (12/12/08).
15 Herschend v. Director of Rev., 896 S.W.2d 458 (Mo. 1995).
16 MO DOR Letter Ruling LR 5309 (12/12/08).
17 CA FTB Notice 2010-02 (12/3/10).
18 Beamer v. Franchise Tax Bd., 563 P.2d 238 (Cal. 1977).
19 Appeal of Dayton Hudson Corp., 94-SBE-003 (Cal. State Bd. of Eq.
20 Appeal of Kelly Services, Inc., 97-SBE-010 (Cal. State Bd. of Eq.
21 34 TX Admin. Code §3.588.
22 The instructions to the Texas Franchise Tax Report state that
"[g]enerally COGS for franchise tax reporting purposes will not equal the amount
used for federal income tax reporting purposes or for fnancial accounting
purposes. . . . It is a calculated amount specifc to the franchise tax" [Form
05-395, 2011 Texas Franchise Tax Report Information and Instructions, p.
15 (December 2010)).
23 TX Tax Code Ann. §171.1013(c). This
amount is adjusted annually for infation beginning in 2010 [§171.006[b)).
24 FASB, "Minutes of the August 2, 2006
Board Meeting on Potential FSP: Texas Franchise Tax" (8/2/06).
25 OH Rev. Code §5751.02.
26 OH Rev. Code §5751.01(A).
27 OH Rev. Code §5751.01(F).
28 Ohio Grocers Ass'n v. Levin, 916
N.E.2d 446 (Ohio 2009).
29 MN Notice 08-08 (7/21/08).
30 MA DOR Directive 08-7 (12/18/08).
31 SC Rev. Rul. 09-10 (7/17/09).
32 WI Dep't of Rev., Wis. Tax Bull., No.
147, p. 21 (April 1, 2006).
33 MI Comp. Laws §201.1201.
34 MI Comp. Laws §208.1203(2).
35 MI Comp. Laws §208.1281.
36 MI Comp. Laws §§208.1201(1) and
37 MO DOR Letter Ruling LR 5309
38 SC Rev. Rul. 09-10 (7/17/09); KS DOR
Opinion Letter No. O-2009-05 (3/24/09).
39 OK Stat. tit. 68, §1218.
40 OK Stat. tit. 68, §1212.1.
41 OK Stat. tit. 68, §1218(A).
42 OK Stat. tit. 68, §1218(B).
43 OK Stat. tit. 68, §1218(C).
44 OK Stat. tit. 68, §1217(7).
45 Southwestern Bell Tel. Co. v.
Oklahoma State Bd. of Equalization, 231 P.3d 638 (Okla. 2009).
46 OK Stat. tit. 68, §1218(F).
47 OK Stat. tit. 68, §1218(H).
48 OK Stat. tit. 68, §1217(10).
49 OK Stat. tit. 68, §1217(6).
50 See the online appendix for a summary
of the entity-level tax payments assessed by these states.
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